Value added tax or VAT for short is probably one of the most common taxes we come across in our day to day lives although on many occasions you won’t even realise you’re paying it. The prevailing vat rate is applied to lots of the products and services we consume so chances are you’ve already paid a considerable amount. In this article we will look at the ins and outs of VAT including where VAT is applied, where you may see a different vat rate, and who collects it.
This Article Contains
What Is VAT?
VAT is a tax applied to most products and services sold throughout the UK and the EU. At each stage of production or whenever “value is added” the VAT element is also increased hence the name value added tax. In some other countries you may hear it referred to as GST or goods service tax which applies similar principles. The way that VAT is accounted for and collected in the UK means that it is the end user that bares the full cost but they are often blissfully unaware – just look at your receipt next time you visit the supermarket, you should see that many of the products you purchase are subject to VAT and the price you see on the shelf is actually the VAT inclusive price.
VAT is collected by businesses who have registered for VAT with HMRC. They are responsible for collecting the tax where necessary and paying it across to HMRC. This sounds like a lot of responsibility but there are also some perks that come with VAT registration which we will explore throughout the article.
Which VAT Rate To Use
In the UK we have a number of different rates for VAT and which VAT rate is applied will depend on the type of goods or service being sold. The list below is not exhaustive but provides some examples of products and services that fall under each different VAT rate The full list can be found on the HMRC website.
HMRC will usually announce changes to a VAT rate that will coincide with the start of a new tax year however they can actually change the rates whenever they see fit. As VAT rates can have a big impact on how much the consumer pays for a product or service, by lowering the rates they can encourage spending so changes are often used as economic stimulus.
A good example of HMRC using VAT rate cuts as a form of stimulus took place recently when they temporarily cut the rate of VAT for hospitality, holiday accommodation and attractions from 20% to 5%. This VAT rate cut will remain in place until 12 January 2021 and is a response to the COVID-19 pandemic.
You will notice in the table above that there is a VAT rate category for zero rated supplies and a category for exempt supplies (sometimes referred to as outside the scope. Many people assume that these are the same as they both result on no VAT being charged but technically they are different. Zero rated products and services are still subject to a VAT rate of 0% whereas exempt products and services are not subjected to VAT at all. This seems like a strange concept but it’s main implication can be seen when calculating taxable turnover as zero rated sales are included in taxable turnover whereas exempt items are not. You will need to calculate taxable turnover when deciding if you need to register for VAT which we will look at in more detail below.
You can download a full list of VAT Rates and the industry groups.
VAT Registration Threshold
A business must register for VAT if any of the following criteria are met:
- VAT taxable turnover exceeds £85,000 on a rolling 12 month basis (the last 12 months).
- VAT taxable turnover is expected to exceed £85,000 in a single 30 day period.
- A business only sells VAT exempt goods or services but it makes purchases in excess of £85,000 from VAT registered businesses within the EU.
VAT taxable turnover can be calculated by adding together all the sales a business makes that are not exempt from VAT. This is where a good knowledge of the difference between exempt items and zero rated items is needed as zero rated items are included when calculating VAT taxable turnover.
Once one of the above criteria are met a business will have 30 days to register for VAT but they may need to start charging VAT on sales before this. We will look at when to charge VAT later in the article.
Sometimes a business may want to register for VAT even though it isn’t legally required to. This is called a voluntary registration. There are a number of reasons a business might want to do this this including wanting the business to look more credible but the most common reason is that it can be financially beneficial! That’s right, in some circumstances a business will literally profit from VAT registration.
Example 1 – A IT contractor only provides services to VAT registered businesses. By registering for VAT the contractor will need to charge 20% VAT to their clients (output VAT) but the clients won’t mind as they will claim back the VAT through their own VAT registration meaning it doesn’t actually cost them anything and they will already be used to doing this. As a result of the registration the contractor can now reclaim the VAT on any purchases made by the business (input VAT). This input VAT will be deducted from the output VAT before paying the difference across to HMRC.
Example 2 – A self employed builder purchases land to build a residential dwelling. As a a new build residential dwelling the sale of the dwelling is zero rated so a VAT registration will not impact the sale price but by registering for VAT the builder will be able to reclaim VAT on any VAT taxable materials used in the development process. As there is no output VAT collected the input VAT will result in a repayment from HMRC.
A business cannot voluntarily register for VAT if it only makes VAT exempt sales.
Standard Or Flat Rate Scheme?
When a business registers for VAT it will be able to choose between 2 different schemes. The first is the standard VAT scheme where the business will charge VAT on all VAT taxable sales and then offset VAT on all VAT taxable purchases before paying the difference to HMRC.
The second is the flat rate scheme which is designed to ease the administration burden for small businesses. Under the flat rate VAT scheme a business will still charge VAT on all VAT taxable sales at the usual rate. The business is then allocated a percentage that will be applied to gross sales (including the VAT) which will determine how much is paid to HMRC. Under this scheme there is no need to account for VAT on each individual purchase as the business is unable to offset input VAT.
Example – An estate agent registered for VAT on the flat rate scheme invoices a client £10,000 for services rendered. and charges an additional 20% VAT. The gross amount invoiced to the client is £12,000. As an estate agent they are assigned a flat rate percentage of 12%. The estate agent must then pay HMRC £1,440 (12,000 x 12%).
In the above example the estate agent has collected £2,000 of VAT from the client but will only pay HMRC £1,440. The remaining £560 will be treated as income for the company. Under the flat rate scheme the estate agent is unable to offset input VAT from VAT taxable purchases so the £560 is designed to compensate for this.
Under the flat rate scheme each industry is assigned it’s own flat rate percentage which is calculated by HMRC using average figures from other companies operating in the same industry. The flat rate scheme is considered easier to administer for the VAT registered business as well as HMRC and to encourage businesses to register under this scheme HMRC offer a further 1% reduction in the flat rate percentage in the first year of registration after which it reverts back to the official rates. Because an average from the industry is used when HMRC calculate the flat rate percentages, businesses with lower than average input VAT will benefit by being on this scheme whereas businesses with higher than average input VAT would be better off using the standard scheme.
When To Start Charging VAT
Registering for VAT is a simple process and can be done online. You’ll usually receive your VAT registration certificate and VAT number within 30 working days but you might need to start charging VAT before this as the commencement date will depend on the reason for registration.
- If your turnover has exceeded £85,000 in a rolling 12 month period then you will need to start charging VAT on the first day of the second month following the month the threshold was exceeded. So a business that exceeds the threshold on 15th March will need to start charging VAT on VAT taxable sales on 1st May.
- If you expect to exceed the threshold of £85,000 in a single 30 day period then you must start charging VAT immediately.
- If you register for VAT voluntarily you will charge VAT from the effective date of registration which you select when registering.
In some situations you will be required to charge VAT on sales before you have received a VAT certificate and VAT number which can cause issues as you cannot legally charge VAT on an invoice without including a VAT registration number. In this situation it is best to display the VAT inclusive amount as a single total. You can then explain to the client why the invoice is 20% higher than usual and once the VAT certificate arrives you can reissue the invoice displaying VAT number, net amount, VAT amount and gross amount.
Reporting To HMRC
Once your business is registered for VAT it has a responsibility to report it’s VAT Taxable income and VAT taxable expenditure figures to HMRC. This is usually done on a quarterly basis meaning you’ll need to submit 4 returns per year. There is also an option to account for VAT annually by submitting 1 return per year under the annual accounting scheme but this option is much less popular and comes with it’s own requirements.
For the majority of businesses, VAT submissions need to be made electronically via HMRC compliant software since the introduction of the make tax digital scheme. Alternatively you can appoint an accountant to calculate your VAT liabilities and submit returns on your behalf.
The deadline for submitting a return to HMRC and paying any liability are usually the same date. Both must be completed 1 month and 7 days after the end of the accounting period so a return covering the period 1st Jan – 31st March needs to be submitted by 7th May with any liability being paid by the same date.
Failure to meet the filing deadlines can result in penalties so it’s important to stay on top of the reporting.
VAT Cash Accounting
One problem that small businesses can face when registering for VAT is the impact it can have on cash flow. When a business invoices a client for VAT taxable products or services the VAT element of the invoice may need to be paid across to HMRC as soon as 1 month and 7 days later. Where a business offers it’s clients credit terms in excess of this (or the clients are just slow in paying) this can result in the VAT being paid across to HMRC before it is even received by the business.
One way to help with cash flow is to account for VAT under the cash accounting scheme which will ensure VAT is only paid to HMRC once the customer has paid and likewise you will only be able to claim VAT on purchases once they’ve actually been paid for.
To account for VAT under the cash accounting scheme a business must have VAT taxable turnover of £1.35 million or less as it is only designed to assist smaller businesses.
One common mistake we see VAT registered businesses make is not charging VAT on some of the expenses they recharge to clients. It’s an easy mistake to make as often some of the expenses that need recharging didn’t include VAT when they were incurred so it’s quite logical to think that when recharged to the client they should be recharged at the same price and using the same VAT rate. In reality this isn’t how it works. As a VAT registered business you will need to charge VAT on any expenses recharged to a client at the standard VAT rate even when the expense wasn’t originally subject to VAT. A good example of this is a bus ticket which is zero rated. As a form of public transport a VAT rate of 0% is included in the ticket price but when a business recharges a bus ticket to a client on an invoice it would need to add 20% VAT.
VAT On Overseas Transactions
When trading with businesses outside the UK, VAT can become a little more complex and often requires the assistance of an accountant. Whether VAT is charged or not will depend on a number of factors including whether the business your trading with is based inside or outside the EU and whether or not the business is also registered for VAT.
The product or service you are exporting and in what quantity can also impact the way you need to report to HMRC for example businesses who supply digital services within the EU can take advantage of the value added tax mini one stop shop (VAT MOSS) scheme which allows them to report VAT in a single transaction to HMRC rather than registering their business for VAT in each country they operate in. The business will then usually charge the rate of tax applicable in the destination country rather than at the UK rates.
Examples of digital services would include advertising, music sales, software sales, and providing access to the internet.
The VAT MOSS scheme has it’s own reporting requirements and reporting dates and could even be overhauled post Brexit. Due to the complex relationship between VAT and trading overseas we highly recommend seeking the advice of an accountant.
As a VAT registered business HMRC will expect you to:
- Keep details of all sales and purchases made (a trading business should already be doing this)
- Maintain a VAT account (this is used to track how much VAT is owed to HMRC at any given time)
- Issue correct VAT invoices (this includes your displaying your VAT number and the VAT amount clearly amongst other details)